The Institutional Theory of the Firm

Embedded Autonomy

Alexander Styhre

• Publisher: Routledge
• Year: 2019
• ISBN:
  9780429632280
• Edition: 1
• Topic: Commerce
• Subtopic: Comportement organisationnel

The Institutional Theory of the Firm examines recent and previous organization theory literature to advocate what Evans (1995) refers to as the "embedded autonomy" of the firm, as well as its role in being simultaneously anchored in, for example, corporate legislation and regulatory practices on the national, regional (i.e., within the European Union) and transnational levels, while at the same time being granted the right to operate with significant degrees of freedom within this legal-regulatory model. Seen in this view, the embedded autonomy of the corporation represents a theoretical view of the corporation that complements the market-based image of the corporation in economic theory.

When advocating the institutional theory model, three forms of embedded autonomy are examined. First, the corporation is enacted as a legal entity sui juris—as a freestanding "legal person" in corporate law and within the regulatory framework that serves to enforce legislation in everyday life settings. Second, the corporation is embedded within what social theorists refer to as moral economies, the norms and values that regulate what are the socially acceptable and legitimate means for conducting business. Third and finally, the corporation is embedded in governance, a relatively complex economic concept that denotes legal and regulatory control on the societal and economic system levels, and on the level of the individual corporation. By combining the three forms of embeddedness, sanctioned by law, norms, and governance, the embedded autonomy of the firm is secured on the basis of a variety of social practices and resources.

This book brings together a diverse literature including management studies, economic sociology, legal theory, finance theory, and mainstream economic theory to advance the argument that the corporation is best understood as what is embedded in a social and economic context, yet best serving its defined and stipulated ends by assuming considerable degrees of freedom to operate in isolation from various stakeholders. It will be of relevance for a variety of readers, including graduate students, management scholars, policy-makers, and management consultants interested in organization theory and management studies.

1
Embedded Autonomy

An Institutional Theory View of the Firm

Exordium: Are Violations of Social Norms Good for Business?

Coffee (2017), a legal scholar, has recently been paying attention to the role of the shareholder activism of hedge funds, undiversified funds that target illiquid holdings to be able to generate above-the-index returns for its clients, to provide an illustrative, yet alarming case of the consequences of the hedge fund business model. The American pharmaceutical firm Valeant Pharmaceutics has since around 2010 (i.e., after the major finance industry crisis of 2008) has been active in acquiring pharmaceutical companies with prescription drugs in their portfolios. Since 2010, Valeant has invested a total value of over US$36 billion in these acquisitions. When these companies and their prescription drugs were centralized under one management, the next move was to “raise the prices of those drugs astronomically—up to 600 per cent or more” (Coffee, 2017: 223). For instance, in February 2015, Valeant purchased the two drugs Isuprel and Nitropress, which treat abnormal heart rhythm, congestive heart failure, and hypertension episodes—these are apparently no “hair loss therapies” but life-saving medications—for the sum of US$350 million. When the deal was sealed, Valeant “increased their prices by 525% and 212% overnight” (U.S. House of Representatives Memorandum, cited in Coffee, 2017: 223, footnote 9). According to the U.S. House of Representatives Memorandum, it is demonstrated that “Valeant identified goals for revenues first, and then set drug prices to reach those goals”: When this strategy was implemented, Isuprel and Nitropress generated gross revenues of “more than $547 million and profits of approximately $315 million in 2015 alone” (U.S. House of Representatives Memorandum, cited in Coffee, 2017: 223, footnote 9). This strategy, to try to squeeze out the last penny from patients and their insurance companies on the basis of acquisitions and financial engineering, was nothing unique to Veleant. The most extreme case of this procedure was, Coffee (2017: 227, footnote 23) reports, Turing Pharmaceuticals, which “marked up the price of Dataprim from $13.50 per tablet to $750 per tablet” (Coffee, 2017: 227, footnote 23). When Turing Pharmaceuticals’ activities received increased attention and became subject to congressional hearings, the founder and CEO of Turing, Martin Shkreli, a former hedge fund manager, defended Turing’s strategies before Congress by suggesting that “[a]ll drug companies were now following Valeant’s model” (Coffee, 2017: 227, footnote 23). Subsequent news articles published in the United States “have agreed that he was largely correct,” Coffee (2017: 227, footnote 23) writes.

Coffee argues that the business strategies of Valeant and Turing need to be explained on the basis of the current hedge fund business model.¹ The press portrayed Valeant as “a hedge fund hotel,” as there were “a number of prominent hedge funds held large stakes in it or even took seats on its board” (Coffee, 2017: 226). “Symptomatically,” Coffee (2017: 223) argues, “Valeant was emulating the behaviour of activist hedge funds, which characteristically seek in their ‘engagements’ with public firms to reduce the target firm’s investment in longer-term projects in favor of maximizing shareholder payout.” In this case, “maximizing shareholder payout” does not primarily need to avoid investment in projects with limited anticipated returns or to otherwise squander the corporation’s finance capital or other resources to the detriment of shareholders and other stakeholders, but to put patients under medication and their agents under the pressure to pay astronomical amounts of money to merely survive, or to maintain a reasonable quality of life. This business strategy violates social norms and is likely to create negative responses from regulators and the public equally. In this pursuit of shareholder enrichment, unhealthy and vulnerable people were targeted and costs were imposed on all Americans relying on healthcare insurance now and in the future.

The interesting thing is that hedge fund activism is not illegal but merely violates what some would regard as good social norms. This makes hedge funds (whose idiosyncrasies and practices will not be covered here; see, e.g., Coffee and Palia, 2016, for an overview) a particularly interesting species in the finance industry; they serve as a market force that put directors and managers under the heat as their business acumen and integrity are being tested. As Coffee (2017: 223) remarks, “Discussions of corporate ethics and social responsibility often tend to be more aspirational and exhortative than diagnostic,” but the cases of Valeant and Turing and their connections to the hedge fund industry are bona fide, hands-on cases with actual material consequences. The question in the headline of this section asks whether violations of social norms are good for business, but to rephrase that question, to ask whom such violations are good for, one straightforward answer would be “the hedge fund managers” themselves:

Hedge fund managers are so extraordinarily well compensated that in some years the top five hedge fund managers have earned more than all S&P 500 firms’ CEOs combined. Only the hedge fund manager receives a large incentive bonus, and the result is to create a very large incentive to accept risk. Put differently, hedge fund managers profit on the upside but do not necessarily bear much downside risk. Thus, if I get 20 per cent of the profits and 0 per cent of the losses, I am incentivized to accept risk.

(Coffee, 2017: 233)

Representing a general concern regarding the design of the compensation packages of finance industry actors, this compensation model generates considerable externalities that befall third parties—for instance, salaried workers and taxpayers. The current model underprices downside risks as no or inadequate penalties accompany capital losses, whereas the ability to exploit upside risk is generously compensated, which attracts individuals with high-risk appetites to make their careers in the finance industry. Furthermore, Coffee (2017: 233) continues, aggressive and risk-seeking hedge fund managers who target illiquid, yet high-return investment objects such as pharmaceutical companies with a portfolio of prescription drugs create indirect incentives inasmuch as hedge funds with reported substantial above-normal returns attract more investors and clients (on hedge fund growth, see, e.g., Lysandrou, 2018: 55; Cheffins and Armour, 2011: 79): If hedge fund manager are successful, “money will flow into their funds, leading to higher future fees” (Coffee, 2017: 233).

For policy-makers, legislators, regulators, and the wider public, the cases of Valeant and Turing, and their hedge fund connections point at a number of issues to address regarding the capacity of economic systems, including competitive capitalism, to self-regulate and to demonstrate resilience. In this specific case, a small number of the business elites are capable of taking the majority hostage on the basis of shrewd financial engineering and legal loopholes as they can extract enormous sums of money from a collective system designed to provide decent and reasonable healthcare services for American insurance holders and taxpayers. This in turn, to direct the attention to the theme of this volume, casts doubt on the efficacy of the embedded autonomy of the corporation that has been the leading principle for corporate legislation, governance, and economic policy regarding the role of the corporation in a wider societal context—namely, the highly differentiated welfare state wherein enterprising and venturing need to be combined with other social and economic interests, including, for example, private or public healthcare services. That is, the question, “Are violations of social norms good for business?,” may be answered, “It depends!” It could be added that there are for sure cases where this question can be answered affirmatively, but that such extraction of economic value from collective or private resources generates social costs that surface someplace. This question in turn calls for increased attention to the issue of how the private corporation acts, and is intended to act (which, of course, is a source of debates and disputes) within the wider framework of society.

Introduction: The Institutional Theory of the Corporation and the Concept of Embedded Autonomy

This volume is based on the concept and theoretical framework advocated by Peter Evans (1995): embedded autonomy. The corporation is here enacted as what is a legally and managerially autonomous entity that is treated as such in economic reporting and in court cases in the unfortunate event of disputes between business partners or stakeholders. At the same time, this autonomous corporate entity is located in a thick institutional, economic, financial, cultural, moral, and ethical context, wherein a variety of stakeholders and more abstract legislative or normative conditions influence and structure the day-to-day activities inside of organizations. Evans’ (1995) concept of embedded autonomy is helpful as it is indicative of the various legal, regulatory, and managerial tradeoffs and reconciliations that have been accomplished to establish the corporation as a functional vehicle for venturing and enterprising—a legal and socioeconomic innovation that has benefitted economic welfare and social differentiation in considerable ways.

The concern is that this embedded autonomy is a form of a balancing point as various stakeholders want to pull this corporate entity in either direction to benefit their own interest, or to promote other political objectives. Proponents of “embedded liberalism” who grant the sovereign state a key role in promoting and funding, for example, entrepreneurial activities may prefer to even further embed the corporation within the state apparatus and its various agencies, thus blurring the boundaries between “private” and “public,” to better benefit economic growth, employment, or some other defined objective. In contrast, “pro-business” communities may be concerned about the expanding role of a paternal-ist state as they regard such tendencies as what imposes additional costs on enterprising agents, and what dilutes responsibilities and rights, and therefore they seek to further separate the corporation from the influence of, for example, political decisions and regulatory activities. However, as Sklar (1988), who studies the emergence of competitive and corporate capitalism in the 1890–1916 period, remarks, there is nothing “natural” about the current economic system. Instead, corporate capitalism “had to be constructed”—that is, it did not “come on the American scene as a finished ‘economic’ product, or as a pure ideal type” (Sklar, 1988: 15); nor did corporate capitalism “take over” society and simply “vanquish or blot out everything else” (Sklar, 1988: 15). Instead, corporate capitalism was a framework of loosely coupled visions of an economy wherein the corporation was a foremost legal device, conducive of economic venturing and welfare, and which provided various stakeholders with possibilities for advocating their interests within a joint scenario. That is, corporate liberalism, the underlying political ideology of the corporate system, “emerged not as the ideology of any one class, let along the corporate sector of the capitalist class, but rather as a cross-class ideology expressing the interrelations of corporate capitalists, political leaders, intellectuals, proprietary capitalists, professionals and reformers, workers and trade-union leaders, populists and socialists” (Sklar, 1988: 35). This view of corporate liberalism is consistent with how Selznick (1969: 44) defines an institution, as something that is “not an expendable instrument for the achievement of narrowly defined goals,” but that is “valued for the special place it has in the larger social system and for the way it serves the aspirations and needs of those whose lives it touches.” In Selznick’s (1969: 44) account, an institution is part of the social fabric as it “usually serves more than one goal or interest,” and “endures because persons, groups, or communities have a stake in its continued existence.” That is, in Sklar’s (1988) terms, corporate liberalism was viable as it served the interests of a variety of stakeholders, and these stakeholders vindicated corporate capitalism as a palatable solution to defined problems and choice alternatives within the horizon of perceived objectives and possibilities.

The Free Market Theory View: The Market as Spontaneous Order

In order to advocate the embedded autonomy model of the firm, its antithesis, the free market, neoliberal image of the firm needs to be presented. The Austrian economists Friedrich von Hayek is one of the most prominent intellectuals within the free market theory movement, which operated as a subterranean brotherhood during the entire post–World War II period, an era otherwise dominated by Keynesianism and the expansion of the welfare state. In the Austrian school of economics, price theory (see, e.g., Davies, 2010; Ulen, 1994; Hovenkamp, 1985), stipulating that market participants process available public information on the basis of the price-setting mechanism, is the elementary function in an economy, serving to structure and to further differentiate markets. Hayek (1978) believes the markets are “spontaneous orders” that exist before any social (e.g., state-governed or community-based) initiative to shape and form markets. As the spontaneous order of the market is granted an ontological status in Hayek’s thinking, the rule of law, which is a defining feature of a liberal society that protects the individual from the “arbitrary will” of other actors, including not the least the government, merely serves to assist and to further fortify the spontaneous order:

In so far as there is a spontaneously ordered society, public law merely organizes the apparatus required for the better functioning of that more comprehensive spontaneous order. It determined a sort of superstructure erected primarily to protect a pre-existing spontaneous order and to enforce the rules on which it rests.

(Hayek, 1978: 79)

Hayek (1978: 90) refers to the spontaneous order of the market economy as a catallaxy, a neologism derived from its Greek root katallatein, meaning “to exchange,” but also “to receive into the community,” and “to turn from enemy into a friend.” A catallaxy, Hayek suggests, is a spontaneous economic and market-based order wherein exchange between consenting agents generates the largest possible freedom, while simultaneously maximizing the efficiency of economic exchanges. Hayek’s axiomatic idea of the spontaneous market order is arguably the weakest point in his argument as it is both counterintuitive and poorly assisted by empirical data and historical records (see, e.g., Braudel, 1977). Other theorists and scholars have pointed at the role of market-makers (e.g., Vogel, 2018; Jacobides, 2005; Carruthers and Stinchcombe, 1999; see especially the legal theory of finance literature, e.g., Pistor, 2013; Judge, 2017), and not the least the sovereign state in creating functional markets (Vogel, 2018), and have carefully accounted for how the economy is always of necessity constituted “from the bottom-up” within social communities, thus being based on norms, values, customs, standard operating procedures, and so on, rather than simply being given from the outset. In contrast, Hayek simply eliminates all these social complexities and processes and stipulates a market system that predates any other social relations to leverage the market to become a theological or metaphysical concept, serving as a first, axiomatic principle and therefore being protected from the demands to be substantiated by empirical evidence.

Based on the spontaneous order argument, Hayek proceeds to state his preferences regarding the role of the sovereign state vis-à-vis its subjects. Using the term “freedom” but in a most specific and confined sense of the term, Hayek (1967: 229) offers a negative definition of freedom (“freedom from”) as being the “independence of the arbitrary will of another.” This freedom from interventions from the sovereign state and its defined agencies is justified on two grounds. First, liberalism and its stipulated economic freedom that Hayek (1967: 165) advocates is “inseparable from the institution of private property.” The right to own property, earned on the basis of one’s own labor, as John Locke defined in it his Two Treatises of Government (1630), is a constitutional right, but the right to own property is widely accepted and recognized across the political board and is no specific feature of Hayek’s theory of freedom. Second, economic freedom is “the matrix required for the growth of moral values,” Hayek (1967: 230) proposes. Hayek suggests that only a society granting market pricing and free enterprising a central and autonomous role is capable of nourishing the norms and values needed to secure economic freedom. This is a controversial and disputed position as there is ample evidence of markets being dysfunctional, and market actors benefitting from opportunistic behavior, which makes the connections between market pricing and morals tenuous at best, and outright absurd at the lower end.

Nevertheless, based on this negative definition of freedom, in turn justified by the principle of spontaneous orders, floating freely and with no underlying causes or foundation, Hayek dictates a set of rules and principles for the governance of the economy. First of all, any attempts to “correct” or “mediate” the consequences of market pricing is rejected tout court. Hayek (1967: 170) refuses to accept the term “distributive justice” as this is a “conception of justice which did not confine itself to rules of conduct for the individual but aimed at particular result for particular people.” For instance, the sovereign state that implements a progressive income taxation scheme to finance its administration and to fund economic transfer systems to avoid overbearing economic inequality and its consequences is rejected as a form of “a totalitarian order.” In Hayek’s account: “All endeavours to secure the ‘just’ distribution must … be directed towards turning the spontaneous order of the market into an organization, or, in other words, a totalitarian order” (Hayek, 1967: 171). The principles of Keynesian economic theory, and not the least the welfare economics advocated by A.C. Pigou (see, e.g., Pigou, 1951), are thus rejected out of hand by Hayek on the grounds that such policies (1) violate the spontaneous order of the market, and, as a consequence, (2) undermine the individual’s freedom: “The ideal of using the coercive powers of government to achieve ‘positive’ (i.e., social or distributive) justice leads … necessarily to the destruction of individual freedom,” Hayek (1967: 171) writes. In advocating the neoliberal market order, Hayek moves back and forth between highly speculative propositions regarding the nature of economic affairs (the spontaneous order, the concept of freedom derived therefrom, etc.), and hands-on advice of great importance for policy-making and day-today political work, essentially restraining the role of the sovereign state. To advocate principles in abstracto and to turn them into actual policy are two quite different activities, but Hayek is not shy of crossing the boundary and recognizes no concerns when doing so.

Regarding the nature of the firm—the principal subject in this context—Hayek (1967) questions how the political system of democracy can assist the corporation when polity is heavily geared towards making distributive justice its core objective. Consistently following from his economic model, based on the principles of the spontaneous order, economic freedom, and the rejection of any attempts to infringe on these liberties, Hayek (1967) argues that the corporation should be freed from any other responsibilities than to maximize its profits. This is a principle that was famously declared by Milton Friedman in a Newsweek op-ed column in 1970, frequently cited as the locus classicus of the shareholder value governance model, but Hayek maintained this view throughout the entire post–World War II period, arguably making Friedman one of his spokes-persons. Hayek suggests that the corporation should be governed on a profit motive and nothing else as any other “value” would distract managers and directors and suboptimize the use of firm-specific resources. Furthermore, managers and directors are the agents of the shareholders, Hayek proposes, and they cannot impose additional values ...